Whether you have credit card debt, a car loan or another loan, you often have to pay finance charges. A finance charge is the cost to you to borrow the money. The charges are not limited to interest, but include other fees as well. Making a loan payment that is larger than the amount owed can decrease the finance charges in some cases.
Finance Charge Calculation
Banks use one of four methods to calculate the finance charges on a balance. One method multiplies the average daily balance by the annual percentage rate divided by 12. Another method multiplies your daily balance by 1/365 of your APR, according to Bankrate.com. The third method charges you based on the previous month's balance, even if you already paid a portion of the debt owed. For example, if you charged $150 on your card and paid off $100 before the end of the billing cycle, the lender would determine your finance charges based on $150, not the $50 you still owe. The final method determines the charges based on what you owe at the end of the billing cycle.
In the case of credit cards, you should always pay more than the minimum balance to reduce the finance charge you owe. If you only pay the minimum before the end of the grace period, you will owe interest and fees on the remaining balance. The smaller that balance is, the less you will owe. The same holds true for mortgage payments and car loans, with some exceptions. When paying a loan, the goal is to knock down the principal, so that the bank has less to charge interest and fees on.
Avoiding Finance Charges
In the case of credit cards, you can avoid finance charges entirely. To avoid the charges, pay the entire balance in full before the due date. If the card calculates the charges based on the daily balance, the sooner you make a payment, the better. If you carry a balance on card, try to transfer the balance to a card that has no interest or other charges. Pay off the balance before the zero interest rate promotion expires to avoid future charges. Stop using the credit card while paying down the balance so that you do not rack up additional interest or charges.
Car loans and mortgages may contain a prepayment clause. In some cases, the clause stipulates that the lender receives all of the interest you would owe if you didn't make a large, extra payment on the loan, even if you do make an additional payment. For example, if you make a payment of $200 extra, the lender may hold that $200 until the next month, and then apply it to the interest that has accrued, and then apply the remainder to the principal. Review all the loan paperwork closely before you sign to make sure a prepayment clause or pre-computed clause is not in there.
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